Accretion/Dilution Analysis – Part III: Using Debt for Acquisitions

The last two parts of our Accretion/Dilution series focused on all-stock transactions, which are excellent in forming a theoretical understanding of the dynamics at play. However, acquisitions often have a cash component to the consideration, either in-whole or in-part.

How this cash is funded is usually through debt, although excess balance sheet cash-on-hand may also be used.

Choosing Between Funding an Acquisition with Debt or Stock

Unless there are credit constraints, companies will almost always prefer to use debt or excess cash in funding a transaction in order to avoid diluting shareholders. If there is excess cash on the balance sheet, that will almost always be extinguished before debt is issued as the incremental interest on debt is more punitive than the foregone interest earned on cash. However, exceptions include industries that have large restricted cash balances or maintain large cash cushions as mandated by policy, such as airlines.

Soft credit constraints include incremental debt that causes a company will be outside of internal (company targeted Debt/EBITDA as approved by the Board of Directors) or external credit thresholds (Moody’s identifies that Debt/EBITDA cannot exceed a certain amount for an extended period of time before a ratings downgrade).

Hard credit constraints are financial covenants in a company’s bank debt (need a waiver from their relationship banks if they exceed a certain Debt/EBITDA) or breach certain incurrence covenants on their bonds (cannot undertake an acquisition that causes Debt/EBITDA to exceed 4.5x).

Funding a Merger or Acquisition with Cash-on-hand

As alluded to above, if the cash option is available, companies will favor using excess cash over debt and stock. However, most companies do not have large cash piles or “battle-chests”.

This is up to the discretion of the corporate treasury, which may choose to hold a cash cushion or just have liquidity through its bank lines. Theoretically, holding large amounts of cash means that a substantial amount of capital is not being effectively deployed.

Liquidity via committed bank lines (should the company need cash, it can draw on its revolving credit facility and pay small commitment fee when it is undrawn) is much cheaper than the opportunity cost of holding cash – and arguably the company will be paying for the revolver capacity regardless of whether it holds cash. The argument for holding cash is that liquidity is there – until it is not, as evidenced by the crunch from the last financial crisis where liquidity dried up.

The Cost of Debt versus the Target Earnings Yield

For illustrative purposes, we assume a takeover financed entirely by debt. In this scenario, the buyer’s P/E can be ignored as the relevant comparison is the after-tax cost of debt versus the target’s earnings yield (recall, the inverse of the target’s price/earnings ratio). The reason why the after-tax cost of debt is relevant is because interest on debt is tax deductible and creates a tax shield.

If the after-tax cost of debt is lower than the earnings yield of the target, the acquisition is accretive.

Looking at an acquisition funded entirely with cash-on-hand is even more simple, and given that the target company is at all profitable – almost certainly accretive. The relevant comparison to the target’s earnings yield is the foregone interest income from cash. Banks pay practically zero (and sub-zero in some European/Japanese sovereigns due to negative interest rates) for deposits so spending idle cash usually has a low opportunity cost. For any calculation, the cost of cash is the foregone interest on cash less the tax that would have been paid on the interest income.

Funding the Acquisition with Debt Capital Markets in Practice

Of course, the theory is simple – however, finding an appropriate cost of debt is not simple in practice. The company will get an indicative cost of debt for bond issuance from the debt capital markets team based on conversations with fixed income investors and looking at how peers have priced for recent acquisition financings (which change the credit profile of a company unlike straight refinancings of upcoming maturities on existing bonds).

The bank debt will be based on what lenders are willing to give from the corporate banking team. Generally, financing is secured before the transaction is announced – this is paramount in ensuring the deal can go through should debt or equity capital markets collapse when the time to issue bonds comes. As such, the purchase was already funded by a bridge loan provided by the bank group and the buyer and its lenders can go back to the table and figure out how to best structure the M&A.

Accretion/Dilution Example Question 3: Acquiring a Company Using Debt

Company A can raise acquisition debt at a 4% Yield to Maturity. Company B has a price/earnings of 10x. Company A and Company B are both domiciled in the US with an effective tax rate of 40% (35% federal, 5% state tax). If Company A purchases Company B with 100% debt, is the transaction accretive or dilutive?

Inverse of P/E = 10% = Target Earnings Yield

After-Tax Cost of Debt = 4% x (1 – 40%) = 2.4%

The transaction is accretive. The after-tax cost of debt is 2.4%. The earnings yield on Company B is 10%. As such, Company A’s cost of acquisition is 2.4% while it receives a company that pays a 10% return on investment.